The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Contango Oil & Gas Company (NYSEMKT:MCF) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Contango Oil & Gas Carry?
The image below, which you can click on for greater detail, shows that at December 2019 Contango Oil & Gas had debt of US$72.8m, up from US$60.0m in one year. However, because it has a cash reserve of US$1.62m, its net debt is less, at about US$71.1m.
How Strong Is Contango Oil & Gas’s Balance Sheet?
According to the last reported balance sheet, Contango Oil & Gas had liabilities of US$110.5m due within 12 months, and liabilities of US$127.2m due beyond 12 months. Offsetting these obligations, it had cash of US$1.62m as well as receivables valued at US$39.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$196.6m.
This deficit is considerable relative to its market capitalization of US$308.5m, so it does suggest shareholders should keep an eye on Contango Oil & Gas’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Contango Oil & Gas’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Over 12 months, Contango Oil & Gas saw its revenue hold pretty steady, and it did not report positive earnings before interest and tax. While that’s not too bad, we’d prefer see growth.
Importantly, Contango Oil & Gas had negative earnings before interest and tax (EBIT), over the last year. Indeed, it lost a very considerable US$150m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. However, it doesn’t help that it burned through US$133m of cash over the last year. So suffice it to say we consider the stock very risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we’ve spotted 4 warning signs for Contango Oil & Gas (of which 2 make us uncomfortable!) you should know about.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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